Friday, September 01, 2017

How The New Vanguard 403(b)7 Helps and Hurts

What Does The New Vanguard Fee Strategy Mean For Public School Employees?

Last month a client of mine received a letter from Vanguard (see below) outlining some changes in their 403(b) program. The changes are significant and will affect a lot of people in various ways. After reading the letter several times and corresponding with Vanguard I think I have a good grasp of what’s going on and why and I have some advice on how you should proceed.

What Are The Changes?

The first and biggest change is that Vanguard will no longer be the record keeper of their small market 403(b) plans ($20mm and below), the Newport Group will take over those duties.

The second change is that a new fee is being charged. Currently, participants pay $15 per year per mutual fund they hold at Vanguard, regardless of the account balance. This fee can get pretty high if a participant is using multiple Vanguard funds, but it’s quite reasonable if using a single fund (like a LifeCycle or LifeStrategy options). The new fee will be $60 per year regardless of how many mutual funds the participant purchases.

A third change, not mentioned by Vanguard in the letter (but confirmed by Vanguard in an e-mail to me) is the possibility of a fee that will be passed on to the participant by the employer’s compliance administrator. This fee can range from $10 to $36 annually depending on the administrator. Prior to this new relationship Vanguard could not pass such fees on.

On a more positive note, Vanguard is going to offer all participants their Admiral share class, which represents a potentially big savings. They will also begin offering the ability to contribute on a Roth basis and participants will now be able to do loans and hardship withdrawals.

Who Are The Winners & Losers?

My first reaction to the letter was why? Why would one of the largest and most efficient record keepers in the country outsource to a firm a fraction its size? Why is the low-cost leader raising fees instead of lowering them? Why is Vanguard hurting small investors?

The answers are more complicated than you might expect and while many participants are going to feel the pain of this decision, it might end up bringing more employees into the low-cost fold.

The good news first. Admiral shares are a big deal and a great benefit. Vanguard’s Total Stock Market Index currently runs .15% annually for 403(b) participants, this will drop to .04%, almost a 75% drop. Unfortunately, not all Vanguard funds offer an Admiral share class, this includes both their popular Target Date and Target Risk funds, so not everyone will see a drop. Vanguard pushes their Target Dates heavily, so this is a disappointment (but an area of potential improvement).

The new $60 annual fee will benefit those who currently use multiple funds. If you like to build your own portfolio and are currently using four or more funds, you’ll see either no increase or a decrease in fees.

The biggest losers will be small balance accounts who are invested solely in one fund that has no Admiral share class available, namely asset allocation funds. These participants are probably better off rebuilding the asset allocation with the actual Vanguard funds.

Participants may be surprised to find another fee being charged that wasn’t before (note: this may only affect new participants, it’s not universal). Many school employers outsource their 403(b) compliance and pass the cost of that service on to the employee through their account. When Vanguard starts signing on to new school districts they may incur these additional fees. In fact, some current participants may see this fee as well depending on the school district and the administrator. This additional fee will make smaller accounts even more expensive, but there is an upside.

Currently, Vanguard doesn’t sign onto school districts where there is a Compliance Administrator fee because they have no way to pay (they don’t have a mechanism to pass it on), this limits the reach of one of the best 403(b) options in the nation. With the Newport partnership I’m told that Vanguard will expand their presence in the market. This means more participants will have access to a lower-cost provider. The obvious downside is that if you are starting out by contributing only $50 per month, a $60 annual fee plus an additional $30 compliance fee really cuts into your account balance, it’s a tough way to start. But knowing that when your account gets bigger you have the option to move to Vanguard should provide an incentive to grow it quicker.

Ultimately, just the presence of Vanguard could bring down fees overall. My recommendation for people who have Vanguard as an option but are just starting out is to see if there are any other low-cost options that don’t have high annual fees and start there, then move to Vanguard as your balance grows. As much as I can’t stand the NEA selling 403(b) products, they do have a Direct option that could work well as you are growing your balance.

Why is Vanguard doing this?

The main reason is the non-ERISA government 403(b) market is a mess. It’s inefficient, has to many vendors and requires much more to record keep than a traditional single vendor situation. It’s very difficult for 403(b) vendors to create an efficient operation given the number of manual processes involved. Almost everything is a manual process in 403(b) and this means human contact. Human contact means higher costs.

Vanguard can’t run a break-even operation with the expense they charge. In addition, the market is saturated with vendors who charge significantly higher fees and can thus afford to deal with the inefficiencies. Moreover, the other vendors can offer loans, Roth option, hardships and other expected services that Vanguard wasn’t able to do at that price point. By outsourcing to Newport Group, they will be able to offer those services. People who have Vanguard will now be able to take a loan.

The 403(b) market, at least at the public school level is an inefficient mess. Vanguard knows this and instead of abandoning it, it seems they’ve decided to give it another try. It’s never easy to raise fees, but I’d rather have a $60 annual Vanguard account than no access to Vanguard at all.